Streetwise Professor

December 29, 2011

What Side Are You On?

Filed under: Economics,Financial crisis,Financial Crisis II,History,Politics,Regulation — The Professor @ 5:04 pm

The President of the KC Fed, Thomas Hoenig has joined a rather loud chorus clamoring for “Glass Steagall-type” measures to prevent another financial crisis (h/t R). (It should give Mr. Hoenig some pause that LaRouchies are very outspoken advocates of Glass-Steagall, btw.)

I find this nostalgia for Glass-Steagall to be bizarre and disconnected from the realities of Financial Crises I and II. The theory behind Glass-Steagall (and GS-lite measures like the Volcker Rule and the swaps pushout provision of Dodd-Frank) is that banks with insured deposits are subject to moral hazard, and will take on too much risk.  This problem can be reduced by restricting the activities in which banks with insured deposits can undertake.  That is, the problem is deemed to be giving banks too much discretion on the asset side of the balance sheet, when the liability side is insured.

But this bears no relationship to what happened in the 2008 crisis, or the one currently going on.

For starters, most of the major institutions that cratered in 2008 were not universal banks that funded capital market activities (such as underwriting) with insured deposits.  Indeed, the opposite was true.  They were investment banks/broker dealers (Bear, Lehman, Merrill); GSEs (Fannie, Freddie); insurance companies (AIG); commercial or universal banks heavily dependent on wholesale funding; and SIVs (many of which did have connections to commercial banks, admittedly).

Indeed, one could make the case that those who prescribe Son of Glass-Steagall to cure our financial ilss have the diagnosis exactly backwards.  Many of the institutions that cratered–notably the IBs and SIVs–did so precisely because they did not have sticky funding (like insured retail deposits): they relied on short-term, uninsured funding like repo and commercial paper.   Others, like RBS, had some retail deposits, but notably were very dependent on wholesale (uninsured) funding, and that dependence had grown over time.  All of these institutions suffered classic runs.

In this interpretation, it is the concentration of risk in institutions that do not fund primarily through insured deposits that is the problem.  David Murphy has a new paper that looks at Lehman and RBS, and arrives at a similar conclusion.  This would imply that Glass-Steagall is utterly off-point.

The history of banking in the US supports this view as well.  Banking panics occurred throughout the 19th and first-third of the 20th centuries due to funding fragility.  These panics destroyed banks that engaged in traditional banking activities like commercial and real estate lending.  Yes, there were runs on investment houses too (Jay Cooke & Co., Barings) but the point is that it’s the liability side of the balance sheet that matters more than the asset side.  There was tremendous diversity in the asset side of the balance sheets of firms that suffered runs prior to deposit insurance: there was very little diversity on the liability side.  All were funded with short term liabilities that could run at the drop of a hat.

Similarly, S&Ls raped and pillaged deposit insurance even though they were very “narrow banking” institutions with significant restrictions on the asset side of the balance sheet (though those restrictions were eased by Garn-St. Germain in 1984).

As a last point, Financial Crisis II is concentrated in European banks heavily dependent on wholesale funding, and the underlying source of the problem is assets that regulators deemed to be utterly safe for commercial banks–highly rated sovereign debt.  Relatedly, many of the assets that caused commercial and universal banks in the US problems in 2008 were again deemed by regulators to be super-safe, carrying very low (and in some cases zero) capital charges. The assets that are raising/raised questions about the solvency of financial institutions would have been perfectly copacetic even in a Glass-Steagall world.

Which all suggests that the Glass-Steagall focus on the asset side of the balance sheet is completely misguided.  The fragility in the financial system comes from the liability side, and regulators and legislators are terrible at identifying the assets that are “safe” for insured institutions to hold.  Given this, measures to stabilize funding–like deposit insurance, or the existence of a lender of last resort–are key to establishing stability.

Of course this raises moral hazard concerns, but the Friedman-Kraus analysis in Engineering the Financial Crisis convinces me that this was not an important part of Financial Crisis I.  Gorton also argues that the moral hazard effects of deposit insurance have been overstated.  The S&L Crisis was a large part a moral hazard problem, but it occurred in large part because of grossly negligent regulators who (under pressure from Congress) let insolvent thrifts continue to operate rather than shutting them down when their financial condition weakened in the late-70s and early-80s: regulators (and Congress) let readily containable moral hazard flourish.  That crisis also shows that banks have plenty of room to engage in morally hazardous behavior even when they are very narrow institutions with extensive restrictions on the asset side.

Identifying the fragility of liabilities as the true vulnerability of the system of course raises important questions: why do financial institutions routinely rely on run-prone funding, as they have done for centuries? Diamond-Rajan argue that fragile funding plays an important disciplinary role: the threat of a run limits the ability of banks to act opportunistically and expropriate those who lend to them.  This implies that trying to reduce reliability on fragile funding will have a cost: There will be more opportunism.  The hard thing is to design regulations that balance between micro incentives (to control opportunism) and macrostability (arising from the fact that the fragile funding that controls opportunism is vulnerable to jumps to bad coordination game equilibria).

But though I don’t have an answer to what the right balance is, I am pretty confident that it is appropriate to focus more on the liability-side issues as opposed to the asset-side issues.  Which further implies that pining for a return of Glass-Steagall is misguided, and positively dangerous, because it distracts attention from the real problems.

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  1. You’ve been exposed repeating lazy falsehoods about Zerohedge, both here and over at PJM. You’ve spread rumors about them coincidentally at a time that they’re reporting on false re-hypothecation (pretending everyone owns the same gold a bazillion trillion times to keep the price of actual gold own), the CME, and a host of issues that could potentially affect your personal livelihood/consulting.

    You’ve slandered/libeled hundreds of thousands of fellow Americans as potential totalitarians just this week, while claiming their rhetoric lends itself to violence. You’ve failed to denounce your most extreme commenters including vorobey while demanding that Ron Paul trawl through the millions of pro- and con-comments against or for him on the Internet, as does the FDD’s James Kirchuk. You are in short, a hypocrite who cares more about the lack of freedoms in an oligarchic system abroad than here at home.

    My work here is done.

    Gentlemen! I too have been a close observer of the doings of the Bank of the United States. I have had men watching you for a long time, and am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the bank. You tell me that if I take the deposits from the bank and annul its charter I shall ruin ten thousand families. That may be true, gentlemen, but that is your sin! Should I let you go on, you will ruin fifty thousand families, and that would be my sin! You are a den of vipers and thieves. I have determined to rout you out, and by the Eternal, (bringing his fist down on the table) I will rout you out! – Andrew Jackson

    Comment by Mr. X — December 29, 2011 @ 6:08 pm

  2. Mr. X. You wouldn’t know the truth about financial markets if it hit you between the eyes. So your criticism means exactly bupkus to me.

    The ProfessorComment by The Professor — December 29, 2011 @ 6:14 pm

  3. I think you don’t understand the desire to bring back Glass Steagall. In terms or your objective opinion, you are perfectly correct – this was true even when the act was first employed – the large integrated banks like Morgan got through the crisis just fine – it was the smaller un-diversified institutions that got hammered.

    While I would quibble that there is a chicken and egg argument as to asset quality versus liability runs: fears about weak institutions trigger runs on questionable institutions, which stresses the solvent institutions as panic spreads, all generally as part of a larger process of manias (I loved Kindleberger’s book – perfect for an ignorant non quant like myself). However put, it does ultimately come down to a crisis of confidence in the bank’s ability to pay depositors. (Any time someone wants to be bored to death, I would love to discuss pre Civil War Gyro banking and the roll of the New York Clearing House coordinating specie suspensions during panics, particularly the con job pulled by Jackson and Van Buren which shifted control of money policy from Philadelphia to New York with the destruction of the 2nd Bank of the US (hint AJ’s speech and Arthur Schlesinger’s hagiography of it were full of self serving sh*t)).

    Back to the point. The desire for Glass Steagall is a political one: this act stands for the “reforms” of the FDR period and a huge power grab from Washington and the non New York Bankers: it is amusing to note that the KC Fed is now leading the protest – they were the morons who seized the OMC shortly After the death of Strong, and shrank the money supply by 30%. Got it right again, Boys! It also serves to deflect criticism from the political class to the financial classes. For example re CDS, there were plenty of comments by Wrong-way (Greenspan) as to how the CDS was the best thing since sliced bread and that there hadn’t been a major disaster since the 2000-2001 period. To argue that shadow banking wasn’t regulated is to ignore the constant discussions re SIV’s, conduits, etc that went on during the period. Plenty of rules were passed -usually by the RA’s and the CPA Institute, and the Fed’s and congress’ fingerprints were everywhere.

    Above all we must recognize that Government intervention has been a disaster since 1980: the growth of America has occurred in spite of, not because of our policies: consider the following 30 second History. By 1981 the S&L’s assets were worth 60 cents on the dollar due to interest rates (NOT credit quality), and anyone going into a bank would ask for a 3 month CD and a 30 year loan. This was the result of Government policies that were catastrophic, to say the least. To avoid paying the piper we decided to “grow” our way out of this, and with the fall of interest rates had turned an interest rate mismatch into a monumental bad asset problem, and put in place the whole secuitization machine (CMO’s, SIV’s, etc. that would define the next 23 years to date in the markets. After 1987 and when our disaster in the S&L’s in the 1990′s, we embarked on a series of expansions every time there was a crisis, along with a government mandated loosening of credit standards through the agencies,more and more “developments” in putting business assets in trust structures, expansion of the shadow banking world, until in 2007, when the whole edifice cracked and in 2008 came down. The Eurotards, not to be outdone in stupidity, had applied Basil II and were, like good corporatists able to fudge it for another year or two, making the problem worse.

    None of the above gives one much confidence in the roll of government in this process: Getting back to Glass Steagall, we must remember that it was part of the reforms such as the NIRA law which truly were fascist in nature, just a the Europeans are using this crisis to diminish democracy and sovereignty of their members. It is interesting that many OWS and Xian type protestors actually support policies that promote real live fascism, as opposed to true liberty.

    The term useful idiots comes to mind.

    Comment by Sotos — December 30, 2011 @ 10:24 am

  4. @Sotos–thanks for the thoughtful comment.

    1. I was going to update the post to clarify the asset (“chicken-egg”) issue. There is no doubt that there is a linkage between what happens on the asset side and bank runs. The fear that liabilities>assets is what triggers a run. Which means that a decline in asset values–or the perception that a decline has occurred–can cause a run.

    To refine my point: restricting what can be done on the asset side is rather immaterial in determining the likelihood that a run happens. That’s what I was trying to get at by saying that if you look through history, there is tremendous variation on what goes on the asset side of balance sheets of institutions that suffered a run. Even narrow institutions, and institutions investing in what regulators deem “safe”, have suffered runs.

    This makes sense. Institutions have a variety of decision margins that affect the likelihood of a run. Controlling one of those margins is likely immaterial, as they will likely adjust on the other margins to achieve some optimal degree of fragility.

    And to restate the basic point: there are actually arguments for combining riskier assets with sticky funding.

    2. You’re right that I didn’t focus on the political economy of G-S. I was critiquing the substantive arguments, and perhaps the flimsiness of those arguments is strong evidence that the real force behind the G-S revival is along the lines you suggest, i.e., it is a Trojan Horse to expand the power of the Federal gov’t.

    3. Thanks for the nice succinct historical tour. I am clearly in agreement that government intervention post-1980 has been a disaster. It is a perverse irony that people like Hoenig are using the consequences of serial government failure to justify . . . more government control.

    This suggests the reason for the great appeal of corporatism, as opposed to outright socialism, for the political class. There are ready made scapegoats when the policies fail, and the scapegoating is plausible because the proximate cause of of disaster is the action of some ostensibly private actors (e.g., banks) responding to the incentives created by the policies. The policies are the underlying cause, but the causal connections are often obscured–and the policymakers have every incentive to be the main obfuscators.

    The ProfessorComment by The Professor — December 30, 2011 @ 12:40 pm

  5. Agree with all your comments, and sorry about the quibble. Particularly agree with the risky assets sticky deposit comment – most commercial loans are really a kind of partnership, with renegotiation needed when trouble occurs. A stupider form of ownership of such assets than a trust that cannot make needed advances is harder to imagine, even if the lawyers have pushed and twisted the passive trust rules out of all recognition and reason.

    Count me in your amen corner, and a happy new year to ALL.

    Comment by Sotos — December 30, 2011 @ 1:57 pm

  6. @Sotos–no problem. Didn’t bother me in the least. You were right–you just beat me to the punch, and I don’t mind that at all.

    Your comment re trusts is spot on, and that phenomenon is to a large degree the product of capital rules.

    Put your hands on the blog, brother! Can I get another amen? LOL.

    Happy New Year to you and ALL as well. Cheers.

    The ProfessorComment by The Professor — December 30, 2011 @ 2:17 pm

  7. Happy new year all of you , and thank you .

    I am quoting Mark Rzepczynski –The Kindleberger model of crisis

    Kindleberger’s argues that there are three phases to a price process that occur during a financial crisis – mania, panic and crash. This is the more traditional view relative to other analogies such as a hangover or grief “model”.

    Shouting at Amen Corner

    Back around 1900, the center of Bible manufacturing was in lower New York City. The hub of that activity became a popular spot for sidewalk preachers to shout out the old-time religion (thus the song title). … There were so many “Amen!” shouts heard each day, that the term “Amen Corner” evolved.

    New buyers for the assets to be sold have to be given a discount to take on the risk associated with the falling market. In many cases, the stampede can come from a single catalyst, an event that changes the perception on the valuation of the risk assets. -

    Russia urged China to dump its Fannie Mae and Freddie Mac bonds in 2008 in a bid to force a bailout of the largest U.S. mortgage-finance companies, former Treasury Secretary Henry Paulson said.

    Paulson learned of the “disruptive scheme” while attending the Beijing Summer Olympics, according to his memoir, “On The Brink.” -

    Comment by Anders — December 30, 2011 @ 5:18 pm

  8. [...] start with a nice statement of the difficulty of writing good rules from the Streetwise Professor: The hard thing is to design regulations that balance between micro incentives (to control [...]

    Pingback by Deus Ex Macchiato » Quote of the day — January 2, 2012 @ 12:55 pm

  9. What do any of you think of Alan Grayson? Is it appropriate to post a link?

    Comment by Dax — January 9, 2012 @ 2:07 pm

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